Are the Dow’s Doldrums Flashing a Signal?

by Daniel Putnam | August 30, 2013 9:28 am

The U.S. stock market has been suffering from a shaky performance in recent weeks, but the Dow Jones Industrial Average has been particularly weak.

Using ETFs as a guide, the SPDR Dow Jones Industrial Average ETF (DIA[1]) has been hit for a loss of 4% so far in August — short of the -2.7% return for the SPDR S&P 500 ETF (SPY[2]) and well below the positive 3.2% return of PowerSharesQQQ (QQQ[3]).

What’s driving this shortfall — and more important, does it provide any insight on the market outlook?

Why Is the Dow Lagging?

The answer to this question is straightforward, and it can be summed up in three words:

International Business Machines (IBM[4]).

Concerns about slowing growth and rising competitive pressures have driven IBM shares down 5.9% and August and a total of 14.5% from its mid-March high. This has had a major impact on the Dow due to the unique, price-weighted structure of the index. By virtue of being the highest-priced stock in the DJIA at $182, IBM also holds the largest weighting at 9.4% of the index.

As a result, IBM’s downturn has had a much larger impact on the Dow than it has in the S&P 500, where it is weighted at just 1.3%, and the Nasdaq-100 (the index tracked by QQQ), where it isn’t held at all.

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Big Blue isn’t the only culprit in the Dow’s shortfall, however. The venerable index has also suffered disproportionately from the weakness in Exxon Mobil (XOM[6]) — weighted at 4.6% and down 6.3% this month — and Johnson & Johnson (JNJ[7]), which has a 4.5% weighting and is off 6.7%.

At the same time, the Dow has missed out on the recent gains in Apple (AAPL[8]), which has bucked the broader trend to register a positive 9.4% return in August. By virtue of its high share price — $492 at Thursday’s close — Apple hasn’t been added to the Dow because its current price-weighted methodology means the stock would have to enter the index with a weighting north of 20%.

Given that these composition factors can have an outsized impact on the Dow’s return, it’s little wonder that the index receives much more attention from the nightly news broadcasts rather than it does from regular investors.

There Might Be More to the Story

Despite its flaws, the Dow has served a purpose for investors in the past year. The past two times the Dow experienced this sort of divergence from the Nasdaq-100 (NDX[9]), it presaged a short-term downturn in the broader market.

In the first instance — February-March 2012 — the NDX soared 11.6%, but the Dow gained only 4.6%. In the next two months, the two indices were hit for losses of 6.2% and 9.3%, respectively.

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This same phenomenon occurred in August and September of last year, during which the Dow gained 3.3% but was again outpaced by the NDX, which rose 5.9%. In the subsequent six weeks, the market tumbled and the two indices fell 6.7% and 9.7%.

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It also should be noted that similar underperformance occurred in the two months just prior to the market’s first break in autumn 2007, which eventually snowballed into the 2008 bear market.

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Does this mean it’s time to run out and sell all your stocks? Not at all — again, both indices are dominated by a handful of names, and that makes it dangerous to read too much into divergences. But at the same time, investors’ preference for the type of higher-growth stocks found in the NDX — relative to the slower-growth companies that populate the Dow — might represent a type of “flight to quality” that indicates a greater loss of confidence might occur in the weeks that follow.

The takeaway: Be careful how you approach this information, but consider the Dow’s relative performance another potential tool to help assess market direction.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.